Technical Analysis of Stock Prices is Useless

Holidays have been just over and I had some great time with family and friends. I met an old friend in my hometown and most of our conversation was focused on cryptocurrencies. At a certain moment, my friend started to explain his technical analysis on Bitcoin and Bitcoin Cash.

My old friend told me to switch from Bitcoin to Bitcoin Cash, if the price of a Bitcoin retraces from $16K to $8K, because he expected Bitcoin Cash to increase fourfold in that case. He started to explain his theory, but I couldn’t listen to him. His hypothesis that 50% retracement in Bitcoin triggering a 400% increase in Bitcoin Cash sounded farfetched to me.

I could easily discard my friend’s theory, if he didn’t told me to invest in XRP before it increased tenfold.

He is also a successful visual artist and he spends a lot of time looking at live price charts, as trading happens. So, I suspect that he might see some patterns in there. But I’m not 100% sure that the patterns he sees predict the future with statistical significance.

In order to believe in my friend’s technical analysis, I need to do some statistical analysis on his trade results. Until then, technical analysis will be something like fortune telling to me. It might be fun, but not rational or realistic.

Looking at price charts and trying to predict their future reminds me of fortune tellers that look at the remainders of a cup of coffee that you have just drank and tell you what’s going to happen in your future.

What If It Worked?

Let’s assume that technical analysis accurately predicted the price moves in the future. That would create a huge incentive to develop automated trading systems around them. Once those systems got deployed in the field, they would make the signals of technical analysis useless.

Automated trading systems would create instant price gaps as soon as a technical analysis signal got triggered. This is the same effect as how public news move prices. If you think about it, price moves are actually public news. You can’t make any more money from technical analysis than from public news.

Why Do We Buy Into Technical Analysis?

There are several biases and fallacies in play when it comes to technical analysis. One of them is our tendency to see patterns in random data. We intuitively assume that we live in a well-ordered universe and everything has a reason. In reality, we live in a universe where chaos and randomness play a huge role.

Another bias that makes us believe in technical analysis is the optimism bias. What if it was true? We could make a lot of money just by clicking a few buttons. Wouldn’t it be great? Unfortunately, it doesn’t work like that. You can read more about these and other biases and fallacies in the book Thinking Fast and Slow by Daniel Kahneman.

Summary

If you want to preserve and increase your savings, it’s important to base your investment decisions on sound assumptions. Technical analysis is not a sound assumption. If you want to read about which assumptions are sound and which are not, then you can read my previous post.

Disclaimer

This post is published for information purposes only and not meant to be investment advice.

Burak Bilgin
Software developer with a Ph.D. and 15 years of experience. I write daily on personal development and life lessons. Sign up to my email newsletter to receive a weekly overview of my latest content on personal development and life lessons.

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